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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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Well, well, well .... some unlikely allies for Mr Salvini

May 31, 2019

 

 

ref :- "Economists back Salvini in Italy budget dispute" , The Financial Times , International Section

 

We thought we'd point you towards this FT article, which might make some people question received wisdom. Whether it makes the markets do the same is another matter of course, and there's no sign of them doing so this morning. But first ......

 

The world is not a very happy place this morning. According to some of the market reports written earlier yesterday, apparently there were a few optimistic souls reckoning that it was time to take a breather from the "risk-off" trading patterns brought on by trade war escalation and slowing global growth. Poor misguided fools .... what were they thinking ? Right on cue, China ratchets up the threat of retaliation by raising the possibility of withdrawing sales of crucial rare earth to the US. Then President Trump broadens the whole tariff brawl by threatening to slap 5% on imports from Mexico on June 10th  --  rising as high as 25% by the autumn  --  if Mexico doesn't stop illegal immigrants from crossing the border into the States. In doing so of course he simultaneously undermined any confidence in a swift reconciliation between China and the self-anointed "Tariff Man".

 

Just to compound matters , China has released some disappointing factory data this morning and a quick glance at the markets tells us all we need to know about what investors are thinking. It's definitely still "risk-off" strategies to the fore .... in fact it's more classic safe-haven hunting. Strong Jap Yen, Gold higher, and most of all (led by US Treasuries) it's yet more tumbling yields on government bonds as investors scramble for the security they offer. US 10yr Treasuries are yielding just 2.15% (down 6bp from yesterday) , a low for almost 2 years . Along with other European sovereign debt, German 10yr Bund yields are making all-time lows at MINUS -0.209%, surpassing the previous low made during the panic after the UK's Brexit referendum.

 

( **** Whilst we're on the subject, you may also want to have a look at ; "Summer of Fear May Push US Yield to 1.5%, Ignite Yen Rally" on Bloomberg **** )

 

But standing out on our page of sovereign debt yields like a very sore thumb indeed is Italy. With yields on all other major government bonds being marked significantly lower, the yield on Italian 10yr BTPs is UP 6bp this morning. Or looked at another way, lower prices and therefore higher yields suggest that investors just don't consider that Italy's sovereign bonds qualify as the kind of quality safe-haven that they are seeking in times of stress.

 

That's pretty damning , and is of course the result of another long-running battle  -- that between the European Commission and Italian leader (in all but name) Matteo Salvini. (Ah, we've finally made it back to the original chosen FT piece !). The ""received wisdom" we spoke of earlier refers to that held by the EC, and plainly by a large majority of investors. Namely, that Italy must address it's enormously high levels of debt, and UNDER NO CIRCUMSTANCES can it further expand the budget with the kind of "fiscal boost" that Mr Salvini is calling for to boost growth.

 

Conventional thinking would side with the EC's attempted application of fiscal responsibility, and deem Italian plans to expand the level of debt not only a break of the rules, but highly dangerous to both Italy and the wider European project. Or at least, up til now it would. Robin Brooks, chief economist of the utterly orthodox Institute of International Finance, has gone on record to say that the EC's concern is based on "nonsense economics". Assuming Mr Brooks hasn't gone all hippy on us, what can he mean ?

 

It's all down to what's known as the "output gap ". The output gap is essentially the difference between "actual" GDP, and "potential" GDP . As such, it's a measure of how hot an economy is running and the larger the gap, the more room there is to increase spending (to grow the economy) without stoking inflation. The problem is that "potential" GDP cannot be calculated with any certainty, so the output gap is, therefore, a theoretical construct rather than a fact. As with all theories, it ain't necessarily so.

 

In this case .... the EC says that Italy's output gap is an almost negligible 0.3% of national income. That's almost exactly the same as that of Germany (0.2%), and therefore means that Italy's economy has effectively no more scope to grow than Germany's. Aha .... think you can see a possible flaw looming  ? Nevertheless, that's the basis of the EC's opposition to Mr Salvini's spending plans.

 

But Mr Brooks points out that Italy's unemployment is much higher than Germany's. He also tells us that whilst Italian output per capita has fallen 2.6% since 2000, Germany's has risen by 25% .... yes, that's -2.6% compared to +25%. In light of such data, surely any reading that puts those two nations on almost exactly the same footing must be flawed. Apparently, the error in underestimating Italy's "potential" for growth lies in the fact the EC's calculations were based on Italy's recent performance, and not what would be possible with better policies.

 

Now, not everyone agrees with Mr Brooks and to be frank it's hard to imagine a radical re-think about acceptable levels of Italian debt happening anytime soon. But it's refreshing to see established assumptions being challenged, and streetfighter that he is Mr Salvini will doubtless be pleased to use whatever weapons he can find.

 

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